Financial Modeling Best Practices

What is a model? A model is a systematic approach to processing data to arrive at meaningful and actionable outputs in the simplest terms. Modeling is a multidisciplinary skill that is useful across countless fields.

Its most prominent uses lie in finance, accounting, business analysis, programming, biotech, and engineering. Models offer us insights into the possible future outcomes and, as such, are the most important tools in decision-making. They enable us to understand all the facts, figures, and assumptions in a structured manner, thereby helping us to make informed decisions.

With a wide array of use cases, modeling is partly a discipline in itself. However, due to its numerous uses and the fact that most people engaged in modeling are self-taught, there is a lack of standardization. As a result, many financial models fail due to poor design.

A modeler's job is to create robust, appropriate, structured, and transparent models. A good model should ideally seem like a presentation by itself with好的文档。It must ideally be a powerful communication tool that can easily convey the story behind the numbers.

Financial modelingrefers to creating mathematical representations of finance settings from real-world data. There is an ongoing debate about whether it is an art or a science. Regardless, it has gained plenty of attention and has developed a lot since the advent of the digital age.

Financial models best practices: Key considerations

What makes a model effective? Below is a brief list of things that should be considered before building a model.

• Granularity:

It refers to the level of detail that needs to be incorporated into the model and is highly dependent on the purpose behind building it. For instance, if the objective is to arrive at a back-of-the-envelope valuation, the model can be built on simple assumptions with minimal inputs. But if it is going to be the key determinant in pursuing a pivotal project in a company's history, the model developer would be expected to incorporate and model for the most granular details.

• Flexibility:

It refers to the frequency of use of the model, the situations in which it is to be used, as well as the number and knowledge level of its users. A model built for use as a template for frequent use would require far greater flexibility than one that will be discarded after being used for a particular transaction. Flexibility requirements, together with granularity requirements, are referred to as structural requirements.

• Presentability:

A financial model is a tool built to assist in decision-making. Hence, to serve that purpose, it needs to be understandable by all users, especially the decision-makers. The assumptions underlying the model must be clearly defined, with neatly laid out its results and conclusions. It should allow its users to analyze the data further and present the information in different ways depending on their purpose.

• Transparency:

A model should not obscure the flow of the data. Users should trace the origins of different values (be it to another worksheet or another workbook) and understand the formulas used. Complex formulae should be broken down into simpler steps to make them easy to follow. The transparency of a model reduces as its structural requirements (granularity and flexibility) increase.

• Circularity:

这是当一个细胞是指本身。这听起来像a mistake, and in many cases, it is. However, it can be used intentionally, often with error traps and circuit breaker fixes. But to avoid errors, users must ensure that it is intentional, that iterative calculations are enabled in Excel, and that there is an error trap or a circuit breaker formula in place. It can even confuse users who are not well familiar with Excel. Therefore, it is considered best practice to avoid circularity altogether.

• Transferability:

该模型必须在维护其结构和数据完整性的同时转移给其他用户。例如，如果转移到不存在参考文件的其他系统，则从其他工作簿中获取输入的模型可能无法运行。

财务建模最佳实践：准则

Each firm may have its own set of standards to ensure that its people follow the best practices while financial modeling. Nonetheless, users can follow the steps below as a rule of thumb regardless of the firm they work at.

• Clarify the objective:

For best results, start with answering the "why." Determine the purpose behind building the financial model. It is necessary to know the end-users, their requirements, and how they expect to use the model. Modelers must have a clear idea of what their model is expected to deliver.

• Strive for simplicity:

A model is simple when it is transparent and presentable. Users must be easily able to build, follow, modify, and audit it. The complexity of a model increases with granularity and flexibility requirements. Therefore, it is important to strike the right balance between fulfilling the requirements and keeping them simple.

• 计划结构：

Planning is always the key to success. It is highly advisable to plan the flow of data and the layers in the model structure before diving into building it. Users should plan the placement of their input variables, processing workspace, and the necessary output. The input variables may be classified into fixed variables and those that are bound to change periodically. These may be further divided into hard-coded variables and calculated variables. Each kind of variable must be neatly grouped.

• Ensure logical integrity:

Ensuring structural integrity involves limiting the chances of another user accidentally damaging the model's integrity. Data integrity refers to the consistency, completeness, and accuracy of data. Various tools available in Excel help ensure overall integrity, such as Conditional Formatting and Data Validation. In addition, the Trace Precedents tool traces dependencies for formulas and can be useful when auditing a model.

• 格式：

与其他数据以不同的方式格式化某些数据很重要，以乍一看将它们区分开。区分数据对于知道可以做什么或不能做什么很重要。例如，手动输入的数据不能追溯到其他任何地方，某些公式可能是指其他工作表，这可能需要您切换到该表进行遵循。以下是公认的颜色编码方案。

1. Blue:Manually entered data. Inputs and assumptions.
2. Black:公式和同一纸中的引用
3. 绿色的：Formulas and references to other sheets
4. Red:External links to other files.

• 压力测试模型：

This step involves finding flaws in the financial model to improve its quality by testing it to the extreme limits. It ensures that errors do not occur when another user uses the model. The model must be functional and must perform as per expectations. Since they are partly or wholly dependent on assumptions, it is crucial to thoroughly stress-test them.

• 错误检查：

财务数据往往具有结构性的性质。因此，很容易确保在正确的检查中确保数字正确。在模型中插入错误检查可确保公式逻辑正确且完整。建模者还可能有主检查以评估模型是否功能。

财务模型最佳实践：结构

A financial model may have manyworksheets, each with its place and purpose. Logically structuring these worksheets ensures that models are easy to understand, use and audit. Professionals suggest layering the worksheets in the order given below.

• Cover page/worksheet:

这是任何人在工作簿中关注的第一件事。封面页面向新用户提供了有关该模型的简短想法，并清楚地解释了其目的。尽管在所有层中建造最简单，但留下巨大的印象至关重要。它通常包括：

1. A brief description of the purpose and the intended use of the model.
2. An index page that includes each worksheet's description which gives an overview of the model's structure. For ease of use, it may also indicate which worksheets are meant for inputs and outputs or include complex formulas and should be left intact.
3. 版本详细信息在保存新版本时以及进行的关键更改时可能值得注意。如果用户需要在未来进行回顾和扭转任何更改，则可能会有所帮助。对此的需求与模型的复杂性成正比。
4. Legal disclaimers, if applicable.

• Input worksheets:

These worksheets must be easy to understand. People with non-finance backgrounds may often use them. Model developers must ensure that all assumptions and variables are classified into fixed ones and ones that are bound to change periodically. In addition, they may be subclassified into hardcoded inputs and calculated/derived inputs. All inputs must be neatly grouped into these four categories and placed on the input worksheets.

• Processing worksheets:

This is where all the parts of the model join to meet the objective. These worksheets carry complex formulas and calculations. These take the inputs and assumptions, run them through the formulas, and project the output. It is important to ensure that complicated computations are broken down into simpler steps so the model is transparent and easy to understand. This can also be helpful while auditing the model, checking for errors, and fixing them.

• 分析工作表：

These should enable the users to perform sensitivity analyses, scenario analyses, and other studies. Scenarios and sensitivities should be pre-programmed, keeping in mind the objective, the end-users, and the intended use of the model. In addition, they must be useful in making informed decisions.

• 输出工作表：

These are the worksheets that the end-users of the model will use the most. These worksheets should ideally summarize the financial results derived from the model, present an executive summary along with charts and graphs, and include any specific outputs that are required to fulfil the purpose of the model.

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Financial modeling Best Practices: Reducing model risk

在金融中，模型风险是指模型性能不准确而导致的风险。它是称为操作风险的广泛风险类别的一部分。

Many organizations heavily rely on models for their everyday operations and hence must optimize and implement them effectively. Therefore, managing model risk is one of the top items on their priority list. There are two primary reasons as to why model risk may occur.

首先，该模型的设计并非旨在适当地实现其预期目标。其次，将模型用于现实生活案例可能存在问题。此外，以下可能会影响模型风险。

• Assumptions:

Models are simple representations of real-world situations. As with simplifying anything, we often do not consider certain factors or assumptions or consider them wrongly. It is nearly impossible to account for every factor that may arise in the real world which increases the possibility of the actual results deviating from the forecasted figures.

However, it is important to keep in mind that using too many assumptions may result in the overfitting of the model.

• Inputs:

Incorrect choice, measurement, or entry of inputs for use in a model may lead to inaccurate results. It may arise due to incorrect design, human error, or unexpected circumstances. These may also include choosing an inapplicable model or using incorrect model specifications.

• Calculations:

The formulas used may not serve the purpose of the model. In extreme cases, they may be completely wrong. These types of errors include programming and technical errors, implementation issues, calibration errors.

• Analyses:

分析数据经过处理和输出阶段以得出结论。用户可能不会选择合适的分析工具，也可能会错误地解释分析的结果。

模型开发人员还负责创建和维护彻底的documentation for the model。尽管创建有效的文档要求uires long hours and a lot of effort, it is very important. Many organizations specially incentivize this task, as it may not be as lucrative otherwise. Other users engaged in managing model risk must also document their work. It is especially helpful when someone else has to engage in the same activity.

通常通过应力测试和对模型进行回测来减轻模型风险。独立的验证或审核可能有助于及时解决模型中的问题。必须不要让较小的问题导致较大问题。持续监测和对模型的定期重新评估也至关重要。